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A counter-cyclical strategy

One year ago, National Real Estate Investor asked leading players in the net-lease and sale-leaseback financing markets to forecast the state of their business for 2001. Their response? Business would actually benefit from a slowing economy.

Time has proved that prediction to be true. In fact, all of the major players in the specialized arena of net-lease financing report increased business in 2001. Corporate America still wants to get real estate assets off its balance sheet by using the net-lease vehicle.

But Corporate America isn't the only one eyeing the net-lease alternative. Net-lease financing has become an international phenomenon as well. Last November, a consortium led by Stamford, Conn.-based GE Capital, Paris-based CDC IXIS and New York-based Goldman Sachs acquired a $3 billion office portfolio from France Telecom. The group now is in the process of structuring a leaseback arrangement to the firm in what has been called the largest corporate divestment of real estate in French history.

A primer on the net-lease vehicle

According to Boston-based Corporate Realty Investment Co. LLC (CRIC), there is no difference between a “net lease” and a “sale leaseback” from the point of view of the lessor. The only distinction relates to the ownership of the property immediately before the transaction. In a net lease, the lessor buys the property from a third party and net leases it to the lessee. In a sale-leaseback transaction, the lessee owns the property before the transaction, sells the property to the lessor and simultaneously leases it back from the lessor.

From the point of view of the lessee, the distinction between a net lease and a sale-leaseback transaction can be important for accounting reasons, according to CRIC. Under a sale-leaseback deal, the lessee can't have continuing involvement in the property if the lessee wants to preserve the off-balance sheet treatment of the transaction. A continuing involvement includes an option by the lessee to purchase the property or residual interest in the property.

But the basic premise is that a company no longer owns real estate, and for most companies, that's a financial blessing of sorts.

Net-lease independence

Unlike many aspects of the commercial real estate industry, the health of the net-lease market goes beyond the state of the national economy. Net leasing maintains a steady business volume in all stages of the economic cycle. According to Gordon Whiting, executive director and deputy director of acquisitions for New York-based W.P. Carey & Co., the sale-leaseback financing of real estate is an alternative form of financing for companies.

Whiting views the process more as corporate finance than real estate because, in a shaky economy, A-rated companies have far more financing alternatives than non-investment-grade companies do. “There's a liquidity crunch, the banks are squeezing them, everybody's squeezing them,” Whiting says. “There's not a whole lot of lending going on, but they own their real estate and they can sell it and lease it back. So when the economy slows down, our business picks up.”

And so it has. Today, W.P. Carey owns or manages more than 400 commercial and industrial properties throughout the United States and Europe. In a deal completed last year, the company purchased and leased back a 282,000 sq. ft. Class-A office building from Nortel Networks in Richardson, Texas, for $47 million. The building is being leased back to Nortel in a 15-year bond-type net lease.

It is the need for liquidity that seems to have Corporate America's CFOs and treasurers on the hunt for net-leasing advice. “The sale-leaseback is often considered an adjunct business,” says Fred Berliner, senior vice president and director of acquisitions at Miami-based United Trust Fund (UTF). “In a prosperous economy, the company dog is wagging the sale-leaseback tail. Now, with corporate profits declining and uncertainty about the economy, many companies may have a greater need for liquidity.”

Lower corporate earnings are increasing UTF's business, as companies realize they can often generate a profit using a sale-leaseback, which positively impacts their income statements. “Today, at least for the time being, the sale-leaseback tail is wagging the dog,” says Berliner.

Ethan Nessen is the executive vice president at CRIC, which completed about $280 million in net-lease transactions in 2001. According to Nessen, more companies are overcoming their philosophical biases against selling and leasing back their real estate as they realize the transactions can liquefy their assets. “Sale-leaseback activity has increased, and in some cases there is more urgency to it,” he says. “Many companies have to deal with immediate and current capitalization issues that impact operations and rating-agency perceptions.”

Often, the challenge for firms that specialize in net-lease transaction is lining up the institutional money to do the deals. “The window of risk on different types of companies that institutional lenders will lend on becomes narrower and narrower because people want to make investments but they want to be safe. There is a tendency to become overly conservative.”

And for good reason. Economic slowdowns have a way of increasing loan payment delinquencies, as companies struggle to meet earnings estimates, or post any earnings at all.

Whiting says his job involves a great deal of credit analysis: evaluating companies' finances, their industries and their performance outlook during the lease term.

“You can't see out 20 years, but hopefully you can see out three to five years. My job is to make sure I pick companies with good fundamentals that are well-positioned,” Whiting says. “We'll also focus more on the quality of the real estate asset.”

Commercial Net Lease Realty (CNLR), an Orlando, Fla.-based REIT that specializes in net leasing stand-alone retail properties, calculates that lower corporate earnings will mean more business in 2002 as companies review all of their financing options.

Gary Ralston, CNLR's president and COO, expects 2002 to be a good year for the net-lease industry because corporate margins will remain under pressure, leading to lower profits. “Lower earnings means that common stock offerings are not well received, plus margin and earnings pressure means that the rating agencies are taking a more conservative view of corporate debt,” he says. “Thus companies are under some limitation as to additional corporate debt via bond offerings.”

Ralston maintains that many companies will look to sale-leaseback transactions to improve their return on assets. “Since sale-leaseback transactions offer pricing well below a corporation's typical weighted average cost of capital, return on equity also improves,” Ralston says.

Michael Rotchford, head of the finance department in New York-based Cushman & Wakefield's advisory group, says he sees more clients using the net-leasing alternative who previously would not consider it.

“Their basic business was doing well and they were making so much money that they were less focused on the expense side of the balance sheet rather than on the revenue side,” Rotchford says. “Sale-leasebacks and net leases are corporate finance tools that we see a number of our clients investigating at this point. We believe next year we're going to see some fairly substantial transactions in the net-lease industry.”

But Richard Gatto, executive vice president at Chicago-based The Alter Group, disagrees with the net-leasing hype. “Conventional wisdom says that a credit crunch, a faltering economy and weak IPO and debt markets enjoin corporations to seek liquidity by getting real estate off the books,” Gatto says. “That argument, however, neglects the machete that the Fed has taken to the interest rates. With short-term interest rates under 2%, it will be harder for the net-lease industry.”

Gatto says that companies now can do synthetic leasing or corporate borrowing at a lower rate of 5% to 6% vs. the net-lease return of 9% to 10%. A strong-credit company might be able to secure a synthetic lease at a London Interbank Offered Rate (LIBOR) of 4%, according to Gatto.

How low can the economy go?

While the jury is still out on exactly how long or how deep this economic slowdown will be, the net-leasing players make it their business to know what the future holds. But their outlooks differ.

“We view the current downturn as relatively short-term with easing in the second half of 2002,” says Scott Tracy, executive managing director at Los Angeles-based CB Richard Ellis Investors, which has $10 billion in assets under management. “But economic downturns and lower corporate earnings don't have a major impact on our business, which tends to be fairly stable throughout the cycles.”

Whiting says W.P. Carey is well-positioned no matter what happens with the economy. “If the economy continues down, we have access to a tremendous amount of capital to invest. We're coming off a record fourth quarter for us in terms of investments,” Whiting says. “If the economy picks up, companies are going to want to do some financial engineering of their balance sheets, so they're still going to want to do sale-leasebacks. And you're less likely to have a tenant default,” according to Whiting.

CRIC's Nessen says recovery is still further away than Wall Street purports it to be. “I still see too many companies cutting jobs. The economy is not poised for a traditional turnaround,” he says.

Besides that, Nessen observes, this economy is breaking the trends of previous cycles. “During the up-cycle we saw trends we had never seen before. The cycle of a productive economy lasted much longer and had various factors that people didn't understand,” he says.

And the downturn is doing the same. “It's a ‘low-grade virus’ recession where it's not going to have as devastating an impact as other recessions have had. But it will go on a little longer than traditional cycles people are used to,” Nessen says.

Patrick Pearson, vice president of equity investments for GE Capital Business Asset Funding in Bellevue, Wash., says his firm is planning for a tough economic year. “One thing is certain: Competition is fierce in all industries, and we intend to continue our dedication to helping businesses in our markets remain productive, competitive and profitable throughout the year,” Pearson says.

C&W's Rotchford says recovery is imminent. “Internally, we don't believe that corporate earnings will continue to decline.” he says. “This particular downturn has really heightened people's sensitivity to the cost side of the equation.”

Whether earnings are up or down, Rotchford expects corporations to continue to examine their real estate assets next year to see if they are getting the best return.

For his part, CNLR's Ralston is optimistic. “Unless there are some unanticipated political events — acts of terrorism, territorial skirmishes, etc., the economy will clearly be in a recovery mode by sometime in the third quarter,” he says.

Drawing the battle lines

Economic forecasts aside, Corporate America has a number of strong players to turn to in the net-leasing business. So how are these firms differentiating themselves?

One key is their quick and easy access to capital. CNLR, for example, completed a $124 million merger with Ann Arbor, Mich.-based Captec Net Lease Realty in December 2001 to give it a bigger balance sheet. And it raised $170 million through equity offerings in fourth-quarter 2001. Now it has more than $1.1 billion of assets, owning 373 properties in 40 states with a total gross leasable area of 7 million sq. ft.

“Our increased size gives us the capability to do larger transactions that are more meaningful to major corporations without unduly disrupting our diversification,” Ralston says. “Our strong balance sheet provides us significant access to capital, which allows us to deal from a platform of strength.”

That means Ralston is betting that future transactions will require more equity and a stronger sponsor. “We like to think that combining our practical corporate real estate experience with our capital markets capabilities brings Wall Street to Main Street,” he says.

Most net-lease players also are mindful of Sept. 11's impact on their business. “On 9/11, we were reminded of how vulnerable we are as a people,” says UTF's Berliner. He observed that UTF experienced a marked slowdown in business through September and the first half of October. “However, in November there was a tremendous amount of pent-up demand, which manifested itself in an increased number of opportunities.”

Berliner predicts this trend will continue for the foreseeable future and he is betting that more companies will want quick-closing deals and greater flexibility from their financial partners. “A company may tell us that they need to close in four to six weeks. We can accommodate them,” he says. “If a company tells us they need changes to a lease document, we can accommodate them. As long as a company is willing to stay within the concept of a net lease for a term of at least 12 or more years, we can usually accommodate most of their requests,” adds Berliner.

Others companies, including W.P. Carey, will rely on long-standing relationships to bring them business. According to Whiting, the firm has relationships with major investment banks that use sale-leasebacks in company restructuring, as well as private-equity firms looking to reposition their companies to fine-tune their balance sheets.

Whiting also has cultivated relationships with real estate brokers, who are another source of deal flow. “The underlying transaction is a real estate transaction, so we get a lot of repeat business because they can source the kinds of companies and deals we're looking for.”

Other firms, like CRIC, are contemplating major strategic shifts. Although CRIC focused on investment-grade deals in 2001, Nessen says the firm is sniffing out below-investment-grade transactions because it is an underserved marketplace.

“We get a little myopic in our world, and sometimes we start to think that sub-investment grade is bad. But sub-investment grade doesn't mean bad,” Nessen says. “You price the risk and there are some sub-investment grade companies that are probably less risky than some investment-grade companies.”

Gregg Fields, vice president of equity investments for GE Capital Business Asset Funding, says the firm is focusing on the market's demands for streamlined processing. “Our customers have asked us to meet quarterly and year-end accounting timelines,” Fields says. “In response, we are shortening the cycle time for processing transactions.”

Still, everyone in the net-leasing business knows it really is a small world. “It is a competitive business, but at the end of the day, it comes down to pricing and a sense of confidence. There are very few deals that I know about that my competitor doesn't know about, and vice versa,” Nessen says.

And the business keeps attracting more players with deeper pockets. For example, just last December, GE Capital Real Estate and New York-based U.S. Realty Advisors LLC (USRA) formed a strategic alliance to purchase up to $500 million of real estate assets that are net leased to corporations in the United States. USRA will originate the deals and manage the properties.

That kind of commitment can mean only one thing — stay tuned for more.

Ben Johnson is an Atlanta-based writer.

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